ERISA FOR SECURITIES PROFESSIONALS

Transcription

1 ERISA FOR SECURITIES PROFESSIONALS By Richard K. Matta* Part or all of this article is Copyright 2009 Emerald Group Publishing Limited Reprinted with permission SUMMARY The following is an overview of how the Employee Retirement Income Security Act of 1974, as amended ( ERISA ), applies to securities professionals such as registered investment advisers ( RIAs ), registered broker-dealers and individual registered representatives and financial planners who advise, manage, or trade for investment portfolios of private employee benefit plans and individual retirement accounts ( IRAs ). As noted below, ERISA does not apply to governmental plans, which are governed by state law; however, many of the ERISA concepts are followed by governmental plans. The principal focus of this article is on investments in securities registered under the Securities Act of 1933 (the 1933 Act ) and the Securities Exchange Act of 1934 (the 1934 Act ), and securities of investment companies registered under the Investment Company Act of 1940 (the ICA ). Many of these principles also will apply directly to interests in unregistered vehicles, as well as to other investments offered by banks, insurance companies, commodity trading advisers and real estate advisers, though there may be some variation. Key changes resulting from the Pension Protection Act of 2006 ( PPA ) are expressly noted. The law broadly known as ERISA comprises a number of provisions of the Internal Revenue Code (the Code ), the Federal labor laws, and other Federal laws. Except for the prohibited transaction rules of the Code, which fall mainly under the jurisdiction of the Department of Labor ( DOL ) and closely parallel the prohibitions in the labor provisions of ERISA, the Code rules mainly deal with the tax-qualification of plans and are beyond the scope of this discussion. The provisions of ERISA of greatest concern to securities professionals are the labor-law fiduciary requirements contained in Title I of ERISA. These can be broadly divided into five major categories: Coverage and definitions Reporting and disclosure General fiduciary obligations, including co-fiduciary principles Prohibited transactions Enforcement, including bonding requirements Each of these areas is discussed in detail below. GROOM LAW GROUP, CHARTERED 1701 Pennsylvania Ave., N.W. Washington, D.C

2 COVERAGE AND DEFINITIONS A securities professional will be subject to ERISA only if, and only to the extent, that he or she is dealing with ERISA plan assets. For this purpose, there must first be a plan ; the plan must be subject to ERISA; and the assets in question must be plan assets of that plan. Once this determination is made, the next question usually is whether the professional s relationship to the plan is as an ERISA fiduciary or merely as a non-fiduciary service provider. What Is an ERISA Plan? The requirements of ERISA Title I only apply to employee benefit plans, or simply plans, which are further subdivided into pension plans and welfare plans. At minimum, every ERISA plan requires: A plan. Certain ad hoc arrangements covering one or two individual employees usually are not plans. A plan sponsor. Specifically, there must be more than de minimis involvement of an employer or union sponsor. Employees. A plan must cover employees; accordingly, a plan covering only selfemployed individuals and their spouses is not subject to ERISA. Employee benefits. Although not normally at issue, some common payroll practices and employee perks are not employee benefits for ERISA purposes. IRAs and Keoghs. For lack of an employer and/or employees, most individually marketed IRAs and many so-called Keogh plans (including director plans) are not ERISA plans. One major point of confusion, however, relates to the fact that IRAs and Keoghs are benefit plans under the Internal Revenue Code, including the prohibited transaction rules; accordingly, much of the following discussion is also relevant to IRAs and Keoghs. 403(b) plans. Traditionally, 403(b) tax-sheltered annuities were sold directly to employees under the fiction of little or no employer involvement, and thus were not subject to ERISA. However particularly in light of recent IRS rules requiring the adoption of a written plan document more and more 403(b) plans are now subject to ERISA. For securities professionals, the foregoing is mainly an academic exercise; the types of arrangements most frequently encountered, such as traditional tax-qualified pension and profit-sharing plans (including 401(k) plans) are almost always ERISA plans when sponsored by private, non-governmental employers. What Plans Does ERISA Govern? Not all plans are subject to ERISA (and some are partially exempt). Most private employer plans are subject to ERISA (both for-profit and not-for-profit). Governmental plans generally are exempt, although many are subject to similar state-law requirements. For this December

3 reason, many fiduciaries apply their ERISA compliance procedures to governmental plans. Church plans also generally are exempt, but often can elect ERISA coverage. Plans maintained outside the U.S. are not subject to ERISA, if they primarily cover nonresident aliens. What Are ERISA Plan Assets? Every security or other asset owned directly by an employee benefit plan or an IRA is a plan asset subject to ERISA (and/or the Code). The more difficult question is whether an asset owned indirectly is also treated as a plan asset. In theory, the concept of plan assets is simple an entity that is not itself a plan subject to ERISA will be treated as holding plan assets if its primary purpose is to invest retirement plan assets. In effect, ERISA looks through the vehicle, and the persons who manage its assets will be treated as directly managing the assets of the plan. In addition, any business transactions of the entity must be analyzed in light of ERISA's fiduciary and prohibited transaction rules. In practice, these rules are complex and sometimes counterintuitive. ERISA itself defines plan assets only in the negative, exempting registered investment companies and insurance company guaranteed benefit policies. DOL regulations attempt to provide greater guidance. First, they clarify that the concept of plan assets only applies to equity investments; there is no look-through when a plan invests in any true debt instrument. Second, the regulations start with the proposition that you look through every equity investment unless an express exception applies. The principal exceptions in the regulations (in addition to registered investment companies and insurance company guaranteed benefit contracts) are: Publicly offered securities. Such securities must be 1) freely transferable, 2) widely held (more than 100 holders unrelated to management and to each other), and 3) registered under the 1934 Act (or scheduled to be registered subsequent to an IPO), i.e., most public companies. De minimis holdings. Any investment in an entity that does not have significant (25% or more) benefit plan investor participation in any class of equity interests. This is the exception typically used by hedge funds. What constitutes a class of equity interests is not clear, and remains the subject of much debate. PPA note: Before the Pension Protection Act of 2006, the 25% test was applied by treating every retirement plan (and every entity holding plan assets) as a benefit plan investor, whether or not such plan was otherwise subject to ERISA (i.e., including governmental and foreign plans). However, the PPA modified this rule so that only plans subject to ERISA or the Code (including IRAs) are counted toward the 25% test. Moreover, when an entity holding plan assets makes a downstream investment in another entity, it is treated as holding plan assets only to the extent that it has benefit plan December

4 investors (e.g., if it is owned 30% by benefit plan investors, 30% of its assets are treated as plan assets, not 100%). Operating companies. Investments in companies that develop or market goods and services other than the investment of capital, plus certain hybrid entities known as venture capital operating companies and real estate operating companies. Notwithstanding the foregoing, certain entities always are deemed to hold plan assets unless registered as investment companies or publicly traded. These include group trusts (e.g., bank collective investment funds), most insurance company separate accounts, and any entity owned 100% by a single plan or group of related plans (other than an ESOP). Accordingly, for example, if a plan invests in a mutual fund, the RIA that advises the fund as to the investment of its assets will not become an ERISA fiduciary, but any RIA that advises the plan as to its investment in the mutual fund will be a fiduciary. However, if the plan invests in an unregistered hedge fund, both the RIA that advises the plan and the RIA that advises the hedge fund may be fiduciaries. Ordinarily, interests in securitized vehicles (e.g., mortgage pools) that are treated as debt for tax purposes should constitute debt for ERISA purposes. However, the mere characterization of an interest as debt is not sufficient; it must be judged on its merits, including its credit rating. It should also be noted that holding debt of a party in interest raises certain prohibited transaction concerns. See below. Who Is a Fiduciary Under ERISA? ERISA defines three categories of fiduciaries: 1) those who exercise authority or control over the management or disposition of plan assets; 2) those who provide investment advice for a fee with respect to plan assets, or have authority or responsibility to do so; and 3) those who have discretionary responsibility or authority to administer a plan. The Code contains identical definitions for IRAs, and they interpreted consistent with the ERISA rules. RIAs and other money managers typically would fall into one of the first two categories (management of plan assets or investment advice). Broker-dealers acting only as such generally are not fiduciaries; however, certain traditional broker-dealer activities can, in some circumstances, cross the line into investment advice, as discussed below. Financial institutions acting as recordkeepers and third-party administrators typically do not have discretionary responsibility or authority to administer a plan and are not fiduciaries (this role usually remains with the employer); however, having authority to hire or fire other plan service providers may cross the line. The vast majority of questions regarding the fiduciary status of a financial professional revolve around the concept of investment advice. The term has a different meaning under ERISA than under the Investment Advisers Act, as well as different implications: December

5 What is investment advice under ERISA? The definition of investment advice under ERISA is narrower than under the Advisers Act. For investment recommendations to constitute ERISA investment advice, generally those recommendations must: be rendered on a regular basis this affords something of a one-bite exception; be rendered for a fee, direct or indirect; 1 be provided pursuant to an agreement, arrangement, or understanding (which may be implied by course of dealing and reliance); be individualized to the plan s particular needs; and serve as a (not the) primary basis for another plan fiduciary s investment decisions. DOL s employee education Interpretive Bulletin (regulation), discussed below, though not directly applicable to relations between an investment adviser and a plan, provides additional guidance as to what constitutes individualized investment advice. Securities professionals should note that once the line is crossed under ERISA, for purposes of fiduciary liability there is no distinction between discretionary and nondiscretionary investment advice (provided, of course, that the non-discretionary advice is followed by the client). The law remains unresolved as to whether the pension consultant role of recommending managers constitutes investment advice under ERISA. In this respect, it can be argued that the recommendation of an investment fiduciary is neither a recommendation regarding the value of securities or other property, nor a recommendation regarding investing, purchasing, or selling securities or other property under the ERISA regulations. However, there is authority for the proposition that DOL reads the statute more broadly. For this reason, pension consultants often stop short of recommending specific managers and merely offer lists of qualified managers. When does one cross the line between education and advice? In 1996 DOL issued an interpretive bulletin ( IB 96-1 ) indicating what level of investment education services may be provided to 401(k) plan participants and beneficiaries without crossing the line into fiduciary investment advice. IB 96-1 describes four categories of information that may be provided on a non-fiduciary basis: Plan information. This is basically descriptive information. General financial and investment information. This is general advice regarding investment concepts, terminology, risk assessment, etc. 1 This is one part of the definition that financial professionals always seize upon. However, DOL has interpreted the fee requirement very broadly. A financial professional should assume that if he or she is acting under a profit motive, there will be a fee somewhere. December

6 Asset allocation models. Generic models may be provided along with generic information regarding the means by which participants may assess which model to use. The models may relate to specific plan-designated investment options if certain disclosures are made. Interactive investment materials. This extends the asset allocation concept through the use of generic questionnaires, computer programs, and other interactive means to allow participants to assess their retirement needs, goals, risk tolerance, etc. and to apply those assessments to available investment options. Although binding on DOL, whether these guidelines would prevent a plan participant or beneficiary from challenging the fiduciary nature of an asset allocation program is unclear. Although IB 96-1, on its face, applies only to participant-directed ERISA plans, it should also apply equally to self-directed IRAs. Moreover, although it only purports to cover education provided by an employer to employees, the principles that it sets out should apply equally in any other context, such as when an adviser helps a plan sponsor determine an appropriate asset allocation. When do broker-dealer activities become investment advice? The original investment advice regulations under ERISA were designed to ensure that traditional investment recommendations broker-dealers would not, by themselves, be considered investment advice for ERISA purposes. In addition, the regulations contain a safe harbor under which a brokerdealer may be given a limited range of discretion (as to time frame, price range, etc.) within which to execute a trade without becoming a fiduciary. For these reasons, much of the discussion that follows relates only to fiduciary RIAs. However, particularly in the case of smaller plans that come to rely upon the advice of their brokers as a primary source of information on which to make investment decisions, in a number of individual cases DOL and the courts have found that broker-dealers have crossed the line and become ERISA fiduciaries. In addition, the growing practice of providing transition brokerage or transition management services may cause transition brokers to fall outside of the safe harbor for execution to the extent that they are given a greater range of discretion than is permitted under the regulations. In order to fit within the safe harbor, trading instructions provided to a broker must be given by a fiduciary independent of the broker and must specify all of the following: Identity of the specific security(ies) to be bought or sold. Price range within which the security may be bought or sold. A time span for executing the transaction, not to exceed 5 business days. The number of shares (or dollar value) to be bought or sold. PPA note: The PPA added a statutory exemption for the provision of investment advice to participants. This exemption is discussed later in this article. December

7 Who is an investment manager under ERISA (and why does it matter)? An RIA who has actual authority to acquire, manage, or dispose of plan assets can be appointed as an investment manager for ERISA purposes. A bank or insurance company may also be an investment manager. An investment manager must acknowledge its fiduciary status in writing. The appointment of an investment manager under ERISA is not mandatory and is solely for the benefit of the appointing fiduciary. A plan fiduciary who properly appoints an investment manager (and any trustee who follows the manager s directions) generally will not be liable for investment decisions of the investment manager. The appointing fiduciary must be a named fiduciary under the plan, and remains liable for prudently selecting the manager and monitoring its performance. Note: Investment manager status affords no legal benefit for the manager itself. DOL requires that a state-registered adviser that wishes to be appointed as an investment manager must file a copy of its registration electronically with DOL, through the Investment Adviser Registration Depository (IARD). Taft-Hartley Where Does it Fit in? There is often a great deal of confusion as to whether so-called Taft-Hartley plans are subject to ERISA. In fact, they are subject to ERISA in the same manner as any other benefit plan. The 1947 Labor-Management Relations Act, informally known as the Taft-Hartley Act, is a law governing labor relations, not benefit plans as such. It acts as an overlay to the structuring of certain collectively bargained plans, in addition to ERISA. In general, for securities professionals, the key points to note about Taft-Hartley plans or funds are (1) they subject to collective bargaining, usually between a single union and several contributing employers in a single trade or business (hence the alternative term multiemployer plan ); and (2) they are trusteed by an equal number of representatives of the union (union trustees) and the employers (management trustees). This structure has certain practical implications. All costs must be paid from plan assets as there is no separate pool of employer assets to draw upon; one result is that contract indemnities are more limited and often not available. Individual trustees are typically not investment professionals and tend to rely to a greater degree on pension consultants as well as investment managers to insulate them from fiduciary liability. The trust is a committee that must act by majority vote rather than employer fiat. (Note, in particular, that even though the union and management appoint equal numbers of trustees, the management trustees represent multiple companies and tend to have less continuity, so the union trustees often wield disproportionate influence in the decision-making process.) REPORTING AND DISCLOSURE ERISA imposes a number of reporting obligations (to DOL and in some cases to the PBGC or IRS) and disclosure obligations (to plan participants) on plan fiduciaries. These requirements December

8 were substantially modified by the PPA and vary depending on the type of plan (defined benefit, self-directed defined contribution, fiduciary-directed defined contribution). Disclosure requirements may include, among other things, summary plan descriptions ( SPDs ), annual funding notices, periodic benefits statements, and summary annual reports. The administrator of an ERISA plan also must file an annual report with DOL on a 5500-series form. Provided certain requirements are met, disclosures to participants under ERISA may now be made electronically. With limited exceptions, the basic reporting and disclosure requirements of ERISA will not apply directly to plan service providers such as an RIA serving as an investment advisory or investment management fiduciary. The primary reporting and disclosure obligations of securities professionals are those imposed by the securities laws. One exception is that a person managing plan assets will be obligated to provide to the plan administrator certain financial information necessary for the filing of the plan s annual reports, and to cooperate as reasonably necessary in any required independent annual plan audit. Notwithstanding the foregoing, in many cases the service provider may be required by contract to fulfill reporting and disclosure obligations otherwise imposed on the plan sponsor or other plan fiduciary who has retained the service provider. Reporting and disclosure obligations commonly borne by financial institutions include the following: Form 5500 filing by DFEs In some cases, in lieu of assisting directly in the preparation of each plan s annual report, a financial institution advising a separate (non-registered) commingled investment fund holding plan assets may elect to prepare a single entity-level annual report as a direct filing entity or DFE pursuant to DOL regulations. These regulations provide that the fund manager may, within prescribed time periods, file a single audited financial report for the entity with DOL (based on Form 5500). If it does so, the administrator of each investing plan need only report the value of the plan s interest in the entity on the plan s own annual report; otherwise the plan must look through the fund and report its proportionate interest in each of the fund s portfolio holdings. Accordingly, this method of compliance is simpler for all parties and often is mandated in investment contracts involving unregistered investment vehicles. ERISA Section 404(c) Disclosures A participant-directed plan that is structured to benefit from the fiduciary protections afforded by ERISA section 404(c) must comply with certain additional disclosure obligations. Typically, plan sponsors look to financial institutions to provide some or all of these disclosures. The specific section 404(c) disclosure requirements are discussed in more detail below under GENERAL FIDUCIARY OBLIGATIONS - ERISA Section 404(c) Relief from Fiduciary Liability. December

9 GENERAL FIDUCIARY OBLIGATIONS ERISA imposes certain general obligations on plans and their fiduciaries (generally, these rules do not apply to IRAs). Even a non-fiduciary service provider should keep in mind that these rules will impact its activities. Briefly, ERISA s fiduciary obligations (other than the prohibited transaction rules, which are discussed separately) include: Exclusive Purpose/Exclusive Benefit Rule This is the duty of undivided loyalty to the plan, i.e., a fiduciary must discharge its duties solely in the interest of the plan and its participants and beneficiaries, for the exclusive purpose of providing plan benefits and defraying reasonable plan expenses. However, leaving aside the additional protections of ERISA s prohibited transaction rules (discussed below), which often are considered extensions of the exclusive benefit rule to certain specified fiduciary actions, exclusive is read to mean primary, so that this rule is not necessarily violated if another party derives a truly incidental benefit from a plan transaction. Court cases have made clear that under this rule, fiduciaries have a duty not to mislead plan participants when discussing plan-related matters; some courts have begun to expand this duty into an obligation not to mislead by omission or even to impose an affirmative duty to disclose material information. What if this disclosure obligation conflicts with another duty, such as the insider trading rules? In the Enron case, DOL argued, and the court agreed, that there is not necessarily a conflict; insider trading rules are not violated by, and indeed encourage, public disclosure. The result can be a dilemma for corporate insiders who have information that they are not yet ready to release to the public. However, in a 2004 Field Assistance Bulletin for its field enforcement staff, DOL did provide some additional guidance to assist directed trustees and other fiduciaries as to what actions they may be obligated to take if anyone within the organization obtains material non-public information regarding a plan sponsor. Prudence Requirement A fiduciary must act with the care, skill, prudence, and diligence under the circumstances then prevailing that a reasonably prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of like character and with like aims. The highlighted terms distinguish ERISA s prudence rule, often described as the prudent expert standard, from traditional common law good faith prudence standards (though in most states the common law standard has been replaced by the Uniform Prudent Investor Act, which follows ERISA s approach). The prudent expert standard means, among other things, that the level of care imposed on an RIA may vary with the complexity of the investments involved. A 1996 letter from DOL to the Comptroller of the Currency, regarding plan fiduciaries obligations in connection with investments in derivatives, highlights this point. Note that, in theory at least, DOL has embraced modern portfolio theory in applying the fiduciary standards; in practice, however, DOL s enthusiasm sometimes is not so clear. December

10 Moreover, some professionals have questioned whether modern portfolio theory has been properly applied in the retirement plan context, particularly when it comes to frozen plans, i.e., whether asset based investing that starts with a equity-debt presumption, and that looks principally at the plan s assets and risk tolerance to vary the mix, has been so overemphasized that plan liabilities and funding have been overlooked. Thus, the growing interest in liability-driven investment (LDI) and commitment-driven investment (CDI) strategies. Duty to diversify investments ERISA requires that a fiduciary must diversify a plan s investments so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so. For example, the expense of greatly diversifying a small portfolio may not justify the additional protection derived (although there may be other ways of achieving both ends, such as commingling the plan s assets with those of other investors). To the extent that an investment manager is responsible only for a portion of a plan s total assets, its obligation to diversify its own portfolio should be clearly spelled out in its investment management agreement; generally, however, it would remain responsible for diversifying within its range of discretion (e.g., a small cap manager would retain responsibility for maintaining a diversified small cap portfolio). Generally, the duty to diversify does not extend to holdings of employer stock in a defined contribution plan. To the extent that ERISA otherwise permits, and to some extent even encourages, investment in employer securities through various prohibited-transaction exemptions (discussed in more detail below), it also contains an explicit exception to the general fiduciary duty to diversify so long as the investment is otherwise prudent, in the interests of the plan and its participants, and consistent with the plan s documents. Compliance with Plan Documents Plan fiduciaries are required to act in accordance with the documents governing a plan to the extent not inconsistent with the terms of ERISA. For example, if a plan s trust document prohibits certain types of investments, an investment manager who invests in such assets may be in violation of ERISA even if such investments do not violate its investment management agreement. It should be noted that DOL has used the qualifying language in enforcement actions (for example, in the proxy voting context) to challenge fiduciaries who passively adhere to plan terms when it may not otherwise be prudent to do so. In the face of a potential conflict between the terms of a plan and the terms of ERISA, rather than decide which course is correct a fiduciary may wish to consider amending the plan. In the past, RIAs and other service providers have often tried to address the issue of complying with plan documents by obtaining representations and warranties from the fiduciary who hires them on behalf of the plan (i.e., to the effect that the investment management agreement is consistent in all respects with the terms of the plan). However, DOL has indicated that a fiduciary may not be able to rely on such representations, but must obtain and review applicable plan and trust documents. December

11 Trust Requirement ERISA plan assets must be held in trust, with certain limited exceptions (e.g., assets held by insurance companies). These rules, however, do not prohibit 1) the holding of securities in nominee or street name with a custodial bank, insurance company, registered broker-dealer, or clearing agency, provided that a trustee is the ultimate beneficial owner of the securities, or 2) the creation of certain single-owner or commingled investment vehicles (corporation, partnership, LLC, etc.) which hold plan assets, if interests in the vehicles are held in trust. A trustee must be named in the plan or trust documents or be appointed by a named fiduciary and must have exclusive authority or discretion to manage the assets held by it except to the extent that such authority is 1) reserved to a non-trustee named fiduciary or 2) properly delegated to an investment manager (but only to the extent that the manager s directions to the trustee do not on their face violate the terms of the plan or the requirements of ERISA). ERISA does not mandate the use of corporate trustees, and many plans (including most Taft-Hartley plans) have individual trustees. Note, however, that the Code does require that IRA assets must be held by a corporate trustee or custodian. Indicia of Ownership In conjunction with the trust requirement, ERISA requires that the indicia of ownership of any plan assets be held within the jurisdiction of the U.S. Federal District courts. (What constitutes indicia of ownership of an asset generally will be determined by the securities laws or under state/common law.) However, DOL regulations permit the holding of certain foreign securities and foreign currency outside the U.S., provided that they are held 1) under the management or control of a qualified fiduciary, or 2) in the physical possession or control of certain qualifying financial institutions, which fiduciary or custodial institution is a U.S. domestic entity whose principal place of business is in the U.S. Although these requirements are complicated, generally a qualified fiduciary must be a U.S. bank, insurance company, or RIA meeting certain minimum size requirements (in the case of an RIA, $50 million in assets under management and $750,000 equity). A qualifying custodial financial institution must be a U.S. bank, insurance company, or broker-dealer meeting similar requirements, or certain of their foreign agents, provided that certain other requirements are met as to a plan s ability to assert and enforce its ownership rights against the U.S. institution. In early 2008, DOL issued an advisory opinion to Northern Trust regarding its Multinational Cross-Border Pooling Products. The opinion addressed the application of the indicia of ownership requirements in the context of global pooling products. The arrangements described in the opinion involve multiple layers of ownership, management, custody and sub-custody. A global pooling vehicle would be structured as one of several types, typically under the laws of Ireland or Luxembourg. A pooled vehicle may be required to have a local custodian regulated under the law of the jurisdiction where the vehicle is formed. Northern Trust indicated that this would be either Northern Trust (via a local branch) or a local subsidiary of Northern Trust. Where Northern Trust itself is the local custodian, it will also be designated as the global custodian. Where an affiliate is the local custodian, it will appoint December

12 Northern Trust as global custodian (in reality, as a subcustodian). In some jurisdictions, Northern Trust may further appoint a local (foreign) entity as its subcustodian. As an interesting note, Northern Trust further indicated that uninvested US dollar-denominated cash balances would be swept into an Irish sweep vehicle established by Northern Trust, notwithstanding the rule that US currency must be held in the US. Northern Trust appears to have taken the position, and DOL appears to have agreed, that the indicia of ownership rules would be satisfied because the pool would be holding a foreign security (its interest in the sweep vehicle), rather than US currency (a fine line, to be sure). Prohibited Transactions ERISA s prohibited transaction rules are discussed separately below. However, it should be kept in mind that engaging in or failing to prevent a prohibited transaction may be a fiduciary breach separately actionable by DOL or a co-fiduciary (apart from the express penalties imposed on the prohibited transaction itself). Co-Fiduciary Obligations A plan may have multiple fiduciaries with different responsibilities, e.g., a fixed income manager and an equity manager are both fiduciaries, but their responsibilities do not overlap. Nonetheless, one ERISA fiduciary may be held liable for a breach of another fiduciary even if the breach has nothing to do with the first fiduciary s responsibilities if the first fiduciary 1) knowingly participates in, or knowingly undertakes to conceal, the other fiduciary s act or omission, provided that he or she knows that the other party s act or omission is a fiduciary breach; 2) in committing his or her own fiduciary breach, allows the second fiduciary also to commit a breach; or 3) knows of the second fiduciary s breach, unless he or she makes a reasonable effort, under the circumstances, to remedy it. (For example, the foregoing fixed income manager inadvertently discovers that the equity manager has committed a prohibited transaction.) Like regular fiduciary liability, co-fiduciary liability is joint and several; that is, each fiduciary can be sued for the full amount of any damages to the plan, regardless of comparative liability. The full extent of co-fiduciary liability remains to be tested. What if the co-fiduciary obtains its knowledge while acting in a non-fiduciary capacity? What about information obtained by non-fiduciary affiliates? Note that the term co-fiduciary as defined in ERISA has a different (and arguably exact opposite) meaning than its use in the common vernacular. The term is often used by money managers who agree to accept joint liability with a plan's in-house fiduciary typically when recommending 401(k) plan investment options. In that context, the so-called co-fiduciary is really a non-discretionary investment adviser and will have direct and primary liability for its fiduciary recommendations. ERISA Section 404(c) Relief from Fiduciary Liability General. ERISA section 404(c)(1)(A) provides that if a retirement plan permits participants (or beneficiaries) to exercise control over the investment of the assets in their December

13 accounts, and a participant actually does exercise control (as determined by DOL regulations), then: The participant will not be deemed an ERISA fiduciary merely as a result of exercising such control; and No person who is otherwise a fiduciary shall be liable for any loss or breach of ERISA that results from the exercise of control. PPA note: The PPA amended the foregoing to suspend these protections during a blackout period (during which the participant is unable to exercise control) unless the blackout is authorized and implemented consistent with all ERISA requirements. Although simple in concept, this provision by its terms requires implementing regulations. Under the regulations, to qualify for relief, a plan must meet certain requirements, which may generally be summarized as follows: The plan must offer participants a broad range of investment alternatives that allow participants the opportunity to materially affect the potential return on the portion of their individual account under their control, construct a portfolio with risk and return characteristics at any point within a range appropriate for the participant; and minimize risk through diversification. Participants must be permitted to give investment instructions with a frequency that is appropriate in light of the market volatility of the investment alternatives, but not less frequently than once in any three month period, and the plan must comply with specific additional trading frequency rules. Participants must receive or have the opportunity to receive specific information regarding investment alternatives. Though these obligations generally are imposed on the plan sponsor or other named fiduciary(ies), they often fall on service providers by contract or course of dealing. For example, employers often expect that a financial institution offering investment options or investment advice to participants will undertake to ensure compliance or, at minimum, will be in a position to advise the plan sponsor as to how it may meet its compliance obligation. Required disclosures. Information regarding investment options that automatically must be given to all participants includes: An explanation that the plan is intended to constitute a section 404(c) plan and a description of the relief afforded to the plan s fiduciaries by that section. A description of the investment alternatives available under the plan and a general description of the investment objectives and risk and return characteristics of each alternative. December

14 If any option involves retaining an RIA to act as investment manager, identification of the RIA. An explanation of the mechanics of giving investment instructions. A description of any fees imposed with respect to an investment option, e.g., fees imposed directly (such as sales loads, direct management fees, etc.). Fees imposed inside a mutual fund are not imposed on plan assets and are indirect for this purpose. Information identifying a plan fiduciary (usually the plan sponsor, but may be the RIA) who will provide the additional on request disclosures described below. In the case of an investment option that is an employer stock fund, certain additional information. With respect to any investment option that is registered under the 1933 Act (including mutual funds), a copy of the prospectus delivered immediately before or immediately following a participant s initial investment. All proxies and voting materials incidental to a participant s investment choice, and information regarding the exercise of voting and similar rights, to the extent that those rights are passed through to participants under the terms of the plan. In addition to the foregoing automatic disclosures, certain additional disclosures must be made to participants upon request: A description of the annual operating expenses of each investment option, including a statement as to the aggregate amount of such expenses expressed as a percentage of net asset value. Copies of updated prospectuses, financial statements and reports, etc., to the extent otherwise provided (i.e., under the securities laws) to the plan. In the case of investments in (non-registered) vehicles whose assets are ERISA plan assets, certain additional information regarding the underlying investments of the vehicles. Information regarding the value of shares or units in available investment options, including past and current performance information (net of expenses). Generally, it would appear that this information must follow SEC (and NASD) requirements if applicable. Information regarding the value of shares or units in the participant s account. Affirmative directions. A key drawback of section 404(c) is the need to obtain affirmative directions from a participant in order to obtain fiduciary relief. Negative consent is not sufficient. However, affirmative directions are often difficult to obtain from some employees, particularly in the context of automatic enrollment or when plan investment December

15 options change. Accordingly, the PPA amended section 404(c) to permit the use of deemed or negative consent in two circumstances when mapping from an existing investment option to a substitute investment option, and when the employee s assets are placed into a default investment option in the absence of an affirmative investment direction. These special cases are discussed below: Qualified mapping. Section 404(c)(4), added by the PPA, provides that if there is a qualified change in investment options under a plan, and if a participant fails to give affirmative investment directions after appropriate notice, then any assets invested in a changing (generally, discontinued) investment option may be mapped into new options with similar risk and return characteristics. If so, the plan s fiduciaries will not be liable for losses that result from the investment of the participant's account balance in the replacement option(s). Mapping under this provision may be an acceptable option in the context of a simple substitution of similar funds, but generally raises significant questions in the case of more complex plan restructuring transactions. In those cases, plan fiduciaries are more likely to map participant balances into QDIAs. Qualified default investment alternatives (QDIAs). Section 404(c)(5), also added by the PPA, provides that if a plan meets certain notice requirements, a participant who fails to give directions will be treated as exercising control over the assets of his account which are invested by the plan fiduciary in a QDIA in accordance with regulations issued by DOL. DOL issued implementing QDIA regulations in late In early 2008, DOL followed up with certain technical amendments as well a Field Assistance Bulletin ( FAB ) that attempted to answer certain frequently asked questions. Fiduciaries who meet the requirements of the regulation are not liable for losses that result from the investment of the participant's account balance in a QDIA or for investment decisions made by a QDIA investment manager. Nonetheless, like any other investment option, fiduciaries remain responsible for prudently selecting and monitoring the default option (and any investment manager with respect to that option), and may be liable for any losses that result from a failure to do so. Investment managers who manage QDIAs would remain subject to applicable fiduciary standards. Under the regulations, investments eligible for QDIA status generally include balanced funds, certain life-cycle or target-date funds, and managed accounts meeting various conditions. Some plan fiduciaries have begun to look at section 404(c)(5) as a means of periodically forcing participants to reevaluate their investment portfolios by requiring them to make new affirmative elections from time to time. Those who fail to do so are moved into a QDIA. Such an arrangement is sometimes described as a plan reset transaction. December

16 Application of ERISA's Fiduciary Rules to Specific Securities-Related Issues Proxy voting and corporate governance. Generally, unless the authority to vote has been expressly (and properly) reserved or delegated to another fiduciary in accordance with ERISA, the fiduciary who is responsible for the management of securities held by a plan also will be responsible for voting those securities. DOL regulations recommend that plan fiduciaries adopt statements of investment policy and proxy voting guidelines and that those fiduciaries expressly require (i.e., in the investment management agreement) that the manager comply with those statements. Investment managers likewise are encouraged to adopt their own guidelines, particularly with respect to pooled investment vehicles whose investors otherwise may have differing priorities. (Generally, investment guidelines are not plan documents, so that they may be overridden by the management agreement.) Typically, a broad policy of not voting will not be acceptable, though it may be prudent not to vote in certain specific situations, such as where the cost outweighs any potential benefit. For example, the preamble to DOL regulations suggests that foreign securities may sometimes be costly to vote due to the variety of regulatory schemes and corporate practices. More generally, voting very small shareholdings may be costly in terms of staff time/research costs. Economically targeted investments. DOL also has issued various pronouncements with respect to the issue of economically targeted investments, or ETIs and other social investing issues, including most recently in 2008 regarding the use of Taft-Hartley plan assets to promote union organizing and collective bargaining campaigns. These transactions, in effect, take into account non-economic social investment considerations. DOL s position, which remains controversial, is that it is permissible to take non-economic considerations into account only if an investment otherwise satisfies all fiduciary considerations and otherwise is expected to provide no less a return than other investments with similar risk and return characteristics. Employer securities. Even before the Enron and WorldCom cases, it was obvious that holding employer securities in a plan could raise significant ERISA concerns both for employers as well as financial institutions administering plans. Particularly in the case of a troubled company, a key source of concern has been the conflict between following plan terms that mandate investment in employer securities and general fiduciary duties of loyalty and prudence, which may suggest ignoring those terms. Although the law remains unsettled, to date several courts have suggested that there exists a presumption that it is prudent to follow plan terms; in other words, the burden of proof may be on participants to show otherwise. However, this remains a very complicated and volatile area, and more litigation may be anticipated in light of the current economic downturn. The acquisition, holding and disposition of employer securities also raises various prohibited transaction considerations, see below. Late trading and market timing. Generally, many of the issues surrounding the late trading and market timing scandals have been addressed both by plans and by mutual funds December

17 and their advisers. If nothing else, these issues served as a wake-up call to plan fiduciaries to ensure that they are adequately performing their due diligence and monitoring functions. PROHIBITED TRANSACTIONS As an extension of ERISA s fiduciary duties, and in deviation from common-law fiduciary principles, ERISA and the Code incorporate very broad prohibitions against a wide range of activities. These prohibitions extend to a broad group of fiduciary and non-fiduciary parties, and roughly fall into three categories: 1) prohibited transactions between a plan and any party in interest ( disqualified person under the Code), which party need not be a fiduciary; 2) the acquisition or holding by a plan of certain employer securities or employer real property ; and 3) fiduciary conflicts, including self-dealing, direct conflicts (representing a plan and an adverse party in the same transaction), or accepting compensation from a third party dealing with the plan ( kickbacks ). As noted above, these rules also apply to IRAs, with some minor differences. Particularly for securities professionals, it is important to keep in mind that one overriding principle of ERISA s prohibited transaction rules is that they were designed to avoid subjective determinations of violations, even if that result seems harsh. That is at least until the PPA added a service provider exemption, see below there were no broad exceptions for transactions that are reasonable, arm s-length, or based on disclosure and informed consent; however, some or all of these factors may be necessary, but usually not sufficient, steps in complying with certain administrative exemptions. Typically, two of the three broad categories of prohibited transactions are relevant to securities professionals: 1) transactions between a plan and certain parties in interest, sometimes regarded as per se or objective prohibitions because they look only to result; and 2) fiduciary conflicts/self-dealing transactions, which often involve a subjective intent of the fiduciary. Party-in-Interest Transactions Absent an exemption, ERISA prohibits certain direct or indirect transactions between a plan (including a vehicle holding plan assets) and a party in interest to that plan. Who is a party in interest? Parties in interest with respect to a plan include, among others: 1) all fiduciaries of the plan; 2) any person providing services (fiduciary or non-fiduciary) to the plan; 3) any employer or union whose employees are covered by the plan; and 4) numerous parties affiliated with the foregoing in various direct or indirect ways. For a large plan, not even counting employees, there can be hundreds if not thousands of parties in interest. What transactions are prohibited? By definition, virtually any direct or indirect transaction between a party in interest and a plan is prohibited in the first instance, including sales, exchanges, or leasing of property; lending of money or other extensions of credit (by a December

18 plan or to a plan); furnishing of goods or services; and transfers of assets to or for the benefit of a party in interest. Note: In general, when a plan holds an equity interest in a vehicle that does not hold plan assets, it is not a prohibited transaction for the vehicle to engage in a transaction with a person who is a party in interest to the investing plan. However, DOL regulations state that if the plan invests in the vehicle intending or knowing that the vehicle will transact business with a party in interest, the investment may be prohibited. What exceptions apply? Notwithstanding the foregoing, ERISA also recognizes plans needs to engage in certain otherwise prohibited transactions, and so incorporates various statutory exemptions and provides that DOL also may promulgate administrative exemptions. In this respect, certain statutory exemptions relevant to securities professionals include: Reasonable services. Perhaps the most important exemption is the one permitting a party in interest to contract with a plan for services necessary for the establishment or operation of the plan ERISA section 408(b)(2). Regulations indicate that a service is necessary if it is appropriate and helpful to the plan in carrying out its functions. However, the exemption only applies if the arrangement and the compensation are reasonable. The arrangement is reasonable only if it is terminable by the plan without penalty, upon reasonably short notice under the circumstances. It is important to note that this exemption has been interpreted as not extending to any fiduciary conflict (the so-called multiple services issue). For example, unless another exemption applies, an investment adviser would engage in a separate act of self-dealing if it caused a plan to retain its affiliated broker-dealer to execute trades for additional compensation, regardless of whether the arrangement is reasonable. Self-dealing is discussed separately below. Note: In December, 2007, DOL published proposed revisions to its regulations under section 408(b)(2) to incorporate significant new fee disclosure requirements for ERISA plans. The proposal is discussed in more detail below under Hot Topics. Blind transactions. Although not incorporated into the statute per se, ERISA s legislative history indicates that a purchase or sale of securities between a plan and a party in interest would not be prohibited if the transaction is an ordinary blind transaction on a traditional securities exchange (including OTC) where neither party (nor their broker agents) knows the identity of the other. DOL recently issued an advisory opinion extended this concept to an alternative trading system that facilitates block trading (Liquidnet ATS) even though it is possible that the parties identities could become known, provided they take steps to remain anonymous. PPA note: the PPA added a new statutory exemption to ERISA that exempts trades carried out on certain electronic communications networks (ECNs), December

19 even if not technically blind (and even if the RIA or broker has an ownership interest in the ECN), if certain conditions are satisfied with respect to execution mechanics, valuation, and disclosure and consent. Transactions with service providers. Not to be confused with the above exemption for the provision of reasonable services to a plan, ERISA section 408(b)(17) added by the PPA permits a plan to engage in other types of transactions (purchases and sales, loans, leases, etc.) with service providers. It requires that the service provider not have fiduciary authority over the assets in question, and that the plan pay no more than, or receive no less than, adequate consideration. This is a major development, as the original drafters of ERISA expressly rejected the idea of a broad arm s-length exception to the party-in-interest prohibitions. DOL has also promulgated a number of generic or class prohibited transaction exemptions ( PTEs ), which are broadly available to any party in interest who satisfies their conditions. (DOL also issues individual PTEs, applicable only to the identified parties.) Many of these class exemptions apply to party-in-interest transactions involving securities, including: Broker-dealer transactions. The very first exemption, PTE 75-1, broadly exempts certain principal transactions, underwriting, and extensions of credit by nonfiduciary broker-dealers, as well as certain market-making transactions by parties in interest who may or may not be fiduciaries. Generally, the exemption for principal transactions does not apply if the dealer (or its affiliate) is a fiduciary with respect to the assets involved in the transaction. However, there is a specific exception in PTE 75-1 for a broker-dealer who as a fiduciary (directly or in conjunction with its affiliates) receives a fee for causing a client plan to invest in unaffiliated mutual funds. Although styled as an exemption for principal transactions, it is clear that it was intended to cover typical mutual fund distribution (dealer) agreements. The exemption for underwriting (traditional IPOs) should not be confused with the so-called underwriters exemptions, which relate to the underwriting of assetbacked investment pools (see below with respect to mortgage pool investment trusts). Certain IPOs. PTE exempts certain purchases of securities in an IPO where the issuer may use the proceeds to reduce or retire an indebtedness to a party in interest. Securities lending. PTE permits plans to engage in securities lending transactions with counterparties who may be parties in interest. Compared to its predecessor (PTE 81-6), the exemption expands the types of collateral that a plan may accept and enables plans to loan securities to certain foreign banks and brokerdealers. The exemption also clarifies that fee-for-hold arrangements, as well as loans structured as repurchase agreements can qualify for relief. December

20 Short-term investments. PTE 81-8 permits a plan to enter into certain short-term investment transactions with parties in interest, including certain: 1) bankers acceptances; 2) commercial paper; and 3) repurchase agreements (but not reverse repos). Similar individual relief was granted in 1996 to Lehman Brothers in connection with the marketing of synthetic or collateralized GICs ( guaranteed investment contracts ). Mortgage pool investment trusts. PTE 83-1, as amended several times, grants broad relief for a variety of potential prohibited transactions involving plan purchases of interests in certain securitized residential mortgage pools. Numerous individual underwriter exemptions have been granted to almost all financial institutions that participate in the offering of asset-backed investments, and extending this relief to other types of asset-backed pools. QPAM. Traditionally one of the most important exemptions, PTE 84-14, as amended in 2005, broadly exempts transactions effected by a plan at the direction of a qualified professional asset manager, or QPAM. I.e., PTE permits a plan to engage in transactions with third parties, without needing to conduct due diligence to determine whether such third parties may be parties in interest to the plan. A QPAM must be an independent fiduciary and, if an RIA, must have total client assets under its discretionary management of $85 million and shareholders or partners equity of $1 million. The exemption is available with respect to any plan whose assets (combined with those of any affiliated plan) represent no more than 20% of the QPAM s discretionary client assets. The exemption does not cover a party in interest who, at the time of the transaction, has the power to appoint the QPAM as the manager of the plan assets that are involved in the transaction for which relief is sought (subject to an exception for certain smaller investors in a pooled fund). With limited exceptions, the PTE does not apply to transactions with persons related to the QPAM or the plan sponsor. DOL currently is considering an amendment to the exemption that would generally allow a QPAM to provide management services to its own (in-house) plans if certain conditions are met. PPA note: the new statutory exemption for transactions with service providers, discussed above, ultimately may largely replace the QPAM exemption, and DOL already is considering whether QPAM will continue to have any utility in the future. Foreign exchange transactions. PTE permits a bank or broker-dealer, or their affiliates, who may be parties in interest with respect to a plan, to act as principal in a foreign exchange transaction with the plan, provided that the transaction is done at the direction of a fiduciary independent of the bank or broker-dealer. PTE December